Southern California steamroller

Industrial and multifamily sectors lead the way in Southern California, but the outlook is sunny for the office and hotel sectors as well.

Both literally and figuratively, the sun continues to shine on Southern California. The economy is robust with no indication of a downturn anytime soon. Employment is increasing, in terms of both the number of jobs and percentage of people with jobs. And while rents and property costs are rising, compared with the northern half of the state, the region is a bargain.

According to a study from the University of California at Irvine, Orange County alone added 46,000 jobs last year and is projected to add 35,000 to 40,000 this year. The Los Angeles office of Palo Alto, Calif.-based Marcus & Millichap reports Los Angeles County added more than 80,000 jobs in 1999, with an equal number of new jobs projected for this year.

What the U.C. Irvine study finds most significant is that job growth is occurring over a wide range of industries rather than being largely confined to high technology as in the San Francisco Bay Area. In addition, it points out that small- to medium-size firms as well as large corporations continue to expand, creating rapid job growth in business services, computer services and wholesale trade.

According to Haskell & White LLP, an economics consulting firm in Irvine, Calif., Southern California will capture 58% of the state's job growth this year, with high technology, professional services, retail trade and construction leading the way. Though California as a whole ranks first in the nation in its share of jobs in such high-wage growth sectors as management services, biomedical instruments, computers and engineering services, the consultants predict Southern California will capture more than its share of these jobs, with a particularly bright employment future for Orange County.

At the same time, manufacturing and other blue-collar industries still play a significant role in the region's economy. According to the Southern California Regional Association of Governments (SCRAG), the region has more people employed in manufacturing than anywhere else in the nation. The recovering economies in east Asia should particularly benefit the manufacturing sector by boosting overseas demand for California's products.

According to SCRAG, the combined ports of Los Angeles and Long Beach are the third busiest container ports in the world, behind Hong Kong and Taiwan. One quarter of all water-borne trade in the country passes through the Los Angeles-Long Beach complex. The region also has the largest airport system in the world, with international airports in Los Angeles and Ontario and domestic airports in Orange County, Burbank and Long Beach.

In terms of sheer numbers, Southern California is easily the growth champion of the state. According to the Department of the Census, the five counties with the greatest numerical population growth between July `98 and July `99 were, in order, Los Angeles, San Diego, Orange, Riverside and San Bernardino. Altogether they added approximately 330,000 new people to the state's population. Based on projections for the succeeding 12-month period, the total population for these five counties stands at just under 19 million.

Los Angeles, San Diego and Orange counties rank one, two and three in California in terms of population. The combined totals for these three counties in July 1999 comprised more than 45% of the state's total population.

These same three counties have held the top spots in regard to numerical change for the past several years. In the past year, Los Angeles County added 150,200 people, for a total of 9.79 million. San Diego County added 55,200 people to reach an estimated total of 2.88 million during the same period, while Orange County grew by 49,800 people to bring its total to approximately 2.81 million.

Office market equilibrium Southern California's office markets are extremely strong, but they are not experiencing the kind of frenzy occurring in the San Francisco Bay Area. While the Bay Area has three cities that rank among the top 10 markets in terms of office occupancy levels, Southern California has no markets on the list, according to Torto Wheaton Research in Boston.

A report from Layton-Belling & Associates, a Newport Beach-based investor-development company, identifies Southern California as a market in equilibrium, at least in regard to investment. It makes particular note of the fact that rents are rising in line with prices, indicating the equilibrium is likely to last.

Other sources seem to agree. Scott Darling, director of portfolio management for American Realty Advisors, a Glendale, Calif.-based pension fund investment adviser, says the diversity of the economic base, strong growth in the industries that are driving the economy and constraints on new development make the region an ideal investment location.

"We especially like the supply and demand fundamentals," he says. "It's pretty much built out and there's a limited ability to add new product to the marketplace, which means existing product is pretty much bound to rise in value."

At the same time, he adds, the glory days of opportunity investing and large returns are gone, replaced by the promise of generally unspectacular but steady growth over the long term. There are some exceptions that could provide mid-teen returns, he amends, primarily through the redevelopment of existing properties for higher-value use. But even the number of these opportunities is on the decline, he emphasizes.

In Orange County, new office building completions rebounded sharply last year after a seven-year drought with 2 million sq. ft. of new space. This will continue to accommodate business expansions, as well as relocations from Los Angeles, the Bay Area and other states.

In the view of Anthony Manos, senior vice president of investment services for Transwestern Commercial Services in Los Angeles, office rents have reached their peak in most markets, at least for the near future. He hesitates to predict when they will start climbing again, though he says future increases are almost inevitable.

Tight industrial market According to Manos, industrial is one of the two strongest sectors in the region right now, multifamily being the other. He says activity in the industrial sector has been so strong that little product remains on the market, with little likelihood of change. "We're going to see a decrease in sales volume in 2000 because very little product is available," he remarks, noting that the number of recent sales has been so low it is difficult to establish comps.

For the past five years, virtually all significant new industrial development has been relegated to the Inland Empire due to a shortage of land in the traditional industrial areas of Los Angeles and Orange counties. In the traditional markets, demand for industrial space that can be converted to other uses, especially high-tech or biotech, has driven prices to the point where the sale of an industrial development all but guarantees conversion.

According to Manos, pricing has returned to the peak levels of the late 1980s, with properties trading at $60 per sq. ft. up in the Mid-counties and South Bay markets. He estimates both rents and sales prices have jumped about 10% over the past 12 months, with no sign of abatement. By comparison, properties in the Inland Empire have been trading in the range of $30 to $40 per sq. ft.

But Manos says even the Inland Empire is running out of development sites. Exacerbating the situation is the shift in the distribution industry to larger and larger spaces, so that sites that would have sufficed in the past are no longer adequate.

"There are several requirements in the Inland Empire in excess of 750,000 sq. ft., even one for almost 2 million sq. ft.," he says. "Companies need larger configurations of contiguous land. It's very tough to find suitable properties that don't have easement limitations or environmental problems or poor freeway access."

As a result, interest is building in the newly developing Delano area, midway along Interstate 5 between Los Angeles and Bakersfield. Last year the Tejon Ranch Co. opened the 330-acre Tejon Industrial Complex in Kern County for development, and recently IKEA closed on an 80-acre site there for construction of a 1.8 million sq. ft. distribution center. According to Manos, land in Kern County sells for $2 to $2.50 per sq. ft., compared to $4 to $4.50 per sq. ft. in the Inland Empire and $12 to $14 per sq. ft. in Los Angeles and Orange counties.

Retail draws investors The region's retail market has never been stronger, insist most real estate brokerages serving Southern California. According to the Irvine office of Sperry Van Ness, long-term investors have been extremely active buyers in Orange County. The brokerage reports cap rates have averaged about 9%, with well-located properties of no particular distinction selling for prices approaching $300 per sq. ft.

According to Grubb & Ellis, in Los Angeles County same-store sales increased about 6% and overall sales went up nearly 9% last year, with a total of $95 million in retail sales. The brokerage projects more than $100 million in retail sales for 2000.

A similar scenario holds true regionally. A report from the Los Angeles County Economic Development Corp. (LAEDC) says 1999 was marked by unusually high gains in retail sales throughout the five-county Los Angeles metropolitan area. LAEDC chief economist Jack Kyser predicts similarly strong sales this year in Los Angeles, Orange, Riverside, San Bernardino and Ventura counties.

"There's a lot of money out there," agrees Rick Caruso, president of Caruso Affiliated Holdings, a Los Angeles-based shopping center development company. "From a disposable income perspective, there's a lot of new wealth, and people are spending their money."

Despite the generally rosy picture, both Grubb and LAEDC warn of the potential for overbuilding. At the end of first quarter 2000, 5.9 million sq. ft. of new construction was in progress in Los Angeles County, with another 9.7 million sq., ft. planned. As a result, Marcus & Millichap projects a very slight rise in vacancies from 8.4% at the beginning of the year to 9% at the end. At the same time, the brokerage says other factors, including population and income jumps, suggest the market may be able to handle the added space in the long run.

The company also points out that much of the new square footage will be entertainment rather than traditional retail space. Predictably, the region leads the state in the number of entertainment-related projects open or under development, with major projects under way in Hollywood, Anaheim, downtown and Westwood in Los Angeles, Pasadena and elsewhere. The enormous success of Universal CityWalk in Burbank and two projects by the Mills Corp., the Block at Orange in Orange and Ontario Mills in the Inland Empire, have demonstrated that you don't need to be Disneyland to attract large crowds of revelers on a regular basis. Developers throughout Southern California have heard the message.

More surprisingly for a region long regarded as the prime example of the suburbanization of American culture, Southern California also leads the northern half of the state in the number of Main Street and urban village type projects. Even downtown Los Angeles appears on the way to rebirth after half a century of decline.

Several factors have come into play, but by far the most important is continuously worsening traffic congestion. The situation on many freeways and local roads has reached the point where people who once thrived on the region's freewheeling environment now find they prefer to drive as little as possible.

Caruso, whose company specializes in "town center" developments, reports Caruso Affiliated Holdings has five urban village projects totaling 2 million sq. ft. under construction and two others in discussion, as well as others already open, including the Commons at Calabasas and Promenade at West Lake. The demand for such projects has grown geometrically, he says, with each new project increasing public interest.

"We have definitely impacted the traditional enclosed mall," declares Caruso. "There's much more pressure to be in an outdoor environment and much more pressure to make it attractive and entertaining."

According to Candace Rice, senior vice president of leasing and merchandising for Donahue Schriber, a Newport Beach-based retail developer, infill development and repositioning of existing centers offer the best opportunities in Southern California. Though the Inland Empire and Ventura County continue to see residential growth in outlying areas, for most of the region the most common pattern involves consolidation and densification of existing communities.

Along with heightened density, however, escalating land prices have become an area of concern. "Land prices are very challenging," says Rice. "We have very tough criteria with our development pro forma, and that limits our opportunities."

Caruso concurs, though he says the departure of REITs from the marketplace has eased the pressure somewhat. "A couple of years ago, prices got out of control when the REITs jumped in on a major basis," he says.

Unfortunately, land prices are not the only inflationary factor in retail development. According to Caruso, infill, urban village and entertainment projects are all a lot more expensive to build than conventional shopping centers. Structured parking, better design, higher-quality finishes and extra amenities all help drive costs upward. Consequently, to make them pencil out, they have to be built, or rebuilt as the case may be, in areas with either large residential or tourist bases or significant levels of disposable income, preferably both.

Demand grows for multifamily Southern California is currently an ideal multifamily market, say Keith Guericke and Michael Schall, president and CFO, respectively, of Essex Property Trust Inc. The company is a multifamily investment and development REIT based in Palo Alto, Calif.

Noting that the region's apartment rents rose an average of 8% in the first eight months of 2000, Schall says all the underlying factors are in place to keep them rising at a reasonable rate. "There are a lot of high-tech and other well-paying jobs being created, but a minimal amount of housing being created," he says. "So, not only is demand going to continue growing, people are able and willing to pay higher rents."

According to Schall, Essex ranks 24 multifamily markets in the western United States. The seven or eight top locations in terms of investment growth potential, he says, are all in Southern California.

The exception to the scenario, says Guericke, is the Inland Empire, where sufficient land exists to build single-family housing at a reasonable cost. "It's too easy to build there. Single-family homes are too cheap, and as a landlord you can't compete with them. Apartments are primarily transitional housing in the Inland Empire, while in other parts of the region they are long-term options," he says.

According to Hessam Nadji, national director of research for Marcus & Millichap, both Orange and San Diego counties rank among the best markets in the nation, thanks to low vacancies and constraints on new development. In both counties, he says, there is so much pent-up demand that the vacancy rate will stay in the range of 2% to 2.5% for the foreseeable future. He says his firm projects a 7% to 9% rise in rents this year for San Diego County and 7% to 8% rise in Orange County.

Russell Dixon, national senior managing director for CB Richard Ellis in Los Angeles, believes Southern California is not as far along in the overall growth cycle as most other U.S. regions. Though that may be the case, Guericke and Schall say it is nonetheless too far along in the cycle to make investment a sure thing.

"We got to Southern California three years ago, and now a little more than 50% of our portfolio is down there. But the opportunities are diminishing. It's much more difficult to find opportunities now," says Guericke. He emphasizes, however, that Essex's interest lies primarily in properties with potential for substantial added value. Investors seeking long-term investments with dependable returns are in a much better position, he adds.

In certain respects, the region presented a veritable treasure trove of opportunities over the past few years. As Guericke points out, a significant portion of the existing multifamily stock was built in the 1960s and `70s and held by the original owners throughout the intervening period. But as those owners moved into their own 60s and 70s, they began selling off their properties both to relieve themselves of the responsibilities of ownership and take advantage of the extraordinary rise in values that occurred over the past few decades.

Most of the properties that have not been taken by now, however, are four- to 30-unit buildings with only limited opportunity for repositioning. While they can be upgraded to a certain extent, their small size allows for the addition of few amenities such as the swimming pools, exercise facilities, business centers and spas found in typical upscale apartment communities in Southern California today.

Hospitality: occupancy, rents rise According to Art Buser, executive vice president of Jones Lang LaSalle Hotels in Los Angeles, occupancy levels and room rates in Southern California have both gone up 4% and 5% annually since about 1995. The average occupancy level has reached 76% to 77%, but in some submarkets, such as Santa Monica and Beverly Hills, levels exceed 80%, he says.

A report from the Los Angeles office of PKF Consulting shows rates in June 2000 were up 4% to 5% over the same period in `99, topping $121 per night in Los Angeles and $110 per night in Orange County.

Despite the relatively high numbers, little new development is in progress. Buser says high land costs and lack of availability combined with a demanding entitlement process severely limit the production of additional supply. The constraints will continue to force occupancy and room rates upward, he says.

Even the development that is occurring promises little relief because almost all major new hotels are part of mixed-use developments designed to boost tourism.

For example, while Disney will add more than 1,000 rooms to Disneyland with the opening of the Grand California Hotel in January 2001, a month later it plans to inaugurate Downtown Disneyland, a massive retail and entertainment center expected to boost patronage by some 7 million visits per year. According to PKF, other hotels also are in development in Anaheim, but so are other visitor-drawing projects such as an expansion of the Anaheim Convention Center.

In Hollywood, a Renaissance Hotel is being built as part of Toronto-based TrizecHahn's Highland and Hollywood project, which will feature 640,000 sq. ft. of retail, restaurant and entertainment space. It is one of three large retail and entertainment centers in development in Hollywood.

In downtown Los Angeles, the former Sanwa Bank Building at Flower Street and Wilshire Boulevard and the former Bank of California Building at Flower and Sixth Street are being converted to hotels. But the Los Angeles CBD also has new tourist attractions in the works, including the new Walt Disney Concert Hall and a mixed-use center adjacent to the recently opened Staples Center arena.

According to PKF, developers plan several large golf and resort hotels in Orange County, but again these are designed to attract new visitors more than satisfy current demand.

The scenario clearly benefits current investors, bringing very high returns, especially for owners who have owned their properties for several years. The high returns, however, give owners little incentive to sell, says Buser, and when they do, they are asking a high premium that could make it difficult for new buyers to see returns for several years.

So few properties have sold, he adds, that it is difficult to calculate realistic price levels. A perfect example of the difficulty comes from two recent transactions arranged by Chicago-based Jones Lang LaSalle. Though Buser will not discuss prices, according to other industry sources the 250-room Holiday Inn Anaheim sold for $9 million while the 300-room Radisson Agoura in Agoura Hills sold for $31 million. Both are similarly sized, yet the price variation is so great there is no way an investor could use the two sales as the basis for comparison in another buy.

The extreme price variations are explained by several factors. According to Buser, the seller of the Holiday Inn had a ground lease rather than full title, and the property was involved in litigation. The Radisson, on the other hand, was of an age and in a location that made it ripe for repositioning to capture a higher-end clientele.

Even the cap rates indicate little. Again, Buser would not reveal the cap rates, but sources say the Holiday Inn sold at a 5% cap rate and the Radisson at a 10% cap rate, the reverse of what might be expected given the above scenario. But the former buyer will benefit very quickly from its location near a new gate to be opened at Disneyland in conjunction with Downtown Disneyland, while the latter buyer will need to spend $4 million to $6 million to reposition the property.